Small and Mid-Cap Meltdown in the Stock Market
March 2024 — Indian Stock Markets
You might have recently seen headlines regarding the meltdown in small and mid-cap stocks. Much of the blame is placed on SEBI Chairperson Madhabi Puri Buch for alarming the market by stating that there is a bubble in the small-cap space and requesting that mid and small-cap mutual funds conduct a stress test and publish the results. Following this announcement, there has been a significant correction (10 to 20 per cent) in the broader mid and small-cap indices. Since mid and small-cap indices have surged by 50 to 80 per cent, this modest correction cannot truly be considered such a sharp meltdown as portrayed in the press.
What should investors do?
It all depends on one thing — Confidence, how confident are you about the choices you made. And you dont have to answer that. If the Market moves make you afraid now, it means you are not confident enough.
The best test of confidence is a market that is going down — a bear market. When markets go up -in a Bull market, everything goes up and you feel very confident as the price of your picks also goes up. You may believe that you are pretty good in this business. Beware!
One of the reasons why the SEBI chairperson said there is a bubble in certain small-cap stocks is that there was a scam unfolding — a pump-and-dump scheme. Here a wide variety of scripts that do not have enough float or volume are pumped up and the news is spread through social media and by financial influencers which leads to more rallies and then they are offloaded by these buyers. These types of scams are ever present, right from Harshad Mehta to now and even in the future. Even otherwise some stocks are run up like Public Sector units, Defence stocks etc due to general retail traders/investors' euphoria. These have taken a beating.
The problem is that retail investors who buy mostly on price run-ups and know nothing of the company or the sector or its long-term potential will lose all confidence when the price runs down and will start selling, Which will feed the selling frezy by reducing the confidence of other such investors.
An overwhelming majority of people come into the stock market to make money quickly, and an overwhelming majority will initially make some money, which entices them to commit more money. Eventually, most are wiped out and luckily few survive after a Bear run.
To gain the confidence you need either knowledge or the awareness about what you do not know about.
Being aware of your blind spots and weaknesses is a great strength in itself.
You need to understand at what level of knowledge you are operating on.
How much do you know?
Do you understand the relation between demand and supply and its dependencies that spread all across the world? How interest rates in the US are tied to IT companies back home or to the export market. How does the GDP growth rate of China influence the demand for commodities like steel and steel companies' books in India? How the wheat prices due to the Ukraine war were initially threatening inflation all over the world due to a spike in food inflation. And why economists are so concerned with Inflation?
If you do not have any clue related to any of this, and investing based on some ratios like PE (Price To Earnings) or EPS (Earnings per Share) or something similar then STOP. There are no magical financial ratios that are going to reveal the next goldmine. You can still invest, but reduce your risk, that is diversify with very large-cap companies across sectors. These large companies also will many times shockingly go down, but as long as you have diversified well say 10 stocks across a few sectors, then your risks are loq and can slowly start to learn the trade.
Books the way to gain knowledge?
And one way to get confidence is by reading investment books. If you have been uplifted by “One Up on Wall Street”, hung on to “The Man Who Solved the Market” about Jim Simons and not drowned in “Principles: Life and Work” by Ray Dalio or overwhelmed by “The Snowball” about Warren Buffet or that golden classic “The Intelligent Investor” then you are in a stage where you think you know a lot by reading the books. You have a lot of information now.
Information is the basis of Knowledge, but Knowledge comes with experience and applying information to understand and learn from it.
Hopefully, with this information, you will mistake it for knowledge and you will start investing. By reading and understanding books you have a lot of advantages over say eighty per cent of the population who will not read even if their lives depended on it. But still, there is a very high chance that you will be wiped out soon and survive to understand that all these books are telling a different perspective of the truth, but you dont have yet the complete knowledge just by reading.
I will give an example. If you read a book about Mr Warren Buffets or Charlie Munger's investing methodology you will be influenced to think hard and invest all your money in a few companies and sit on it forever. What one does not understand is that we cannot think like Mr Buffet or Mr Charlie Munger. So if we do one part of the advice without heeding the other it is a high-risk investment portfolio you are building.
Another example is reading One Up on Wall Street and following Peter Lynch's strategy of buying the stock in the business that you see or use that is growing very fast. This is an excellent proxy but there may be a lot you dont see behind the fast growth like poor management decisions and too much debt-propelled growth or some other form of leverage which can collapse even with the slightest Black Swan event.
So in short, it is essential to read and re-read books like Poor Charlie’s Almanack, One Up on Wall Street, The Intelligent Investor, The Snowball: Warren Buffett and the Business of Life, The Psychology of Money, Reminiscences of a Stock Operator and other great books, till you put your own money and taste your small losses and learn from it, you are far away from gathering any confidence in your decisions. This means that even if your stock choices are fully right based on the information you have understood and applied, in a Bear market when the price of your stocks plummet you will start doubting, then fearing and finally losing all confidence in your choices and most probably you will cash out at the worst time, when the stock is at the lowest.
Retail investors like us need to diversify our greed till we have enough experience to reduce our fear or lack of confidence in our decisions and therby incur losses because of fear or greed forced actions.
I will leave you with this quote from a great professor who teaches Valuation and is recognised as world’s foremost expert on this — Aswath Damodar
I’ve told people that if at the age of 85 I am on my deathbed and you came and told me, “You’ve spent the last 60 years doing intrinsic valuation and picking stocks, I’ve computed your returns over the last 60 years, and they’re roughly what you have gotten investing in an index fund,” I’d be perfectly OK with it. You need to be OK with it, because what makes investing go off the track is when you believe you are entitled to a high return because you did all the right things. Especially for people who believe in value, that’s a very corrosive thought https://www.moneycontrol.com/news/opinion/aswath-damodaran-investing-is-an-act-of-faith-12466061.html
I highlighted in bold what that mind is trying to say. Happy investing.
